17.1 Calculating the Total Excess: Ratio Leveling vs. Dollar Leveling to Participants

17.1 Calculating the Total Excess: Ratio Leveling vs. Dollar Leveling to Participants

[!NOTE] The Two-Step Statutory Mandate When an employer's 401(k) plan fails the annual Actual Deferral Percentage (ADP) test under IRC §401(k)(3) or the Actual Contribution Percentage (ACP) test under IRC §401(m)(2), the plan administrator must take corrective action to preserve the plan's qualified tax-exempt status under IRC §401(a). The most common correction method is the distribution of excess amounts to Highly Compensated Employees (HCEs).

However, calculating these corrective distributions is not a simple matter of refunding money to the participants who deferred the highest percentages. Under IRC §401(k)(8)(B), IRC §401(m)(6)(B), and Treasury Regulation §1.401(k)-2(b), the Internal Revenue Code mandates a bifurcated, two-step statutory mechanism:

1. Step 1: Ratio Leveling — Determines the aggregate, total dollar pool of excess contributions that must be removed from the plan to bring the HCE group average down to the maximum allowable ADP threshold.
2. Step 2: Dollar Leveling — Allocates that total dollar pool among individual HCEs starting with the participant who deferred the HIGHEST DOLLAR AMOUNT, completely independent of their individual deferral percentages.

For retirement plan administrators and candidates preparing for the ASPPA QKA credential, mastering the mathematical and operational interplay between Ratio Leveling and Dollar Leveling is essential. Failing to grasp this distinction leads to erroneous refund calculations, improper 1099-R tax reporting, and potential qualification defects.

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Legislative History: The SBJPA of 1996 Revolution

To understand why the Internal Revenue Code requires this two-step calculation, one must examine the legislative defect that existed prior to 1997.

The Pre-1997 Percentage-Based Refund Problem

Prior to the enactment of the Small Business Job Protection Act of 1996 (SBJPA), corrective refunds were allocated based entirely on percentages (ratio leveling). Under that legacy regime, the HCEs who had the highest Actual Deferral Ratios (ADRs) received the refunds until the ADP test passed.

This percentage-only allocation produced deeply inequitable and counterintuitive results:

• Consider an HCE earning $70,000 (who met the HCE definition under prior-law rules or ownership) who deferred 10% ($7,000).
• Consider another HCE earning $200,000 who deferred the statutory maximum of $10,000 (an ADR of only 5.00%).
• Under the old percentage-based refund rules, the $70,000 earner with the 10% ADR received the entire corrective refund, while the executive earning $200,000 who actually contributed far more dollars received zero refund!

Congress recognized that penalizing lower-earning HCEs who deferred modest dollar amounts while shielding top-earning executives who deferred maximum dollar amounts violated basic fairness.

The SBJPA Statutory Solution

Effective for plan years beginning on or after January 1, 1997, the SBJPA amended IRC §401(k)(8)(C) and IRC §401(m)(6)(C) to decouple the calculation of the total excess dollar pool from the allocation of refunds to individual participants:

• The Plan-Level Test Remains Ratio-Based: The statutory ADP and ACP testing standards remain percentage-based to protect rank-and-file Non-Highly Compensated Employees (NHCEs).
• The Participant-Level Correction Is Dollar-Based: Once the total dollar excess is determined via ratio leveling, it is distributed to HCEs based strictly on the descending dollar amount of their contributions.

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|                         THE TWO-STEP STATUTORY LEVELING ARCHITECTURE                              |
+---------------------------------------------------------------------------------------------------+
|                                                                                                   |
|   STEP 1: RATIO LEVELING (Treas. Reg. §1.401(k)-2(b)(2)(ii))                                      |
|   • Goal: Determine the TOTAL DOLLAR AMOUNT of Excess Contributions to eliminate.                 |
|   • Method: Hypothetically reduce the HIGHEST HCE ADR down to the next highest HCE ADR.           |
|   • Repeat until the hypothetical HCE ADP equals the Maximum Allowable HCE ADP benchmark.         |
|   • Multiply each hypothetical ADR percentage reduction by the respective HCE's compensation.      |
|   • SUM ALL REDUCTIONS = TOTAL EXCESS CONTRIBUTIONS POOL.                                         |
|                                                                                                   |
|                                                │                                                  |
|                                                ▼                                                  |
|   TOTAL EXCESS DOLLAR POOL ESTABLISHED (e.g., $19,500)                                            |
|                                                │                                                  |
|                                                ▼                                                  |
|                                                                                                   |
|   STEP 2: DOLLAR LEVELING (Treas. Reg. §1.401(k)-2(b)(2)(iii))                                    |
|   • Goal: Allocate the Total Excess Dollar Pool to individual HCEs for distribution.              |
|   • Method: Rank all HCEs in descending order of ELECTIVE DEFERRAL DOLLARS.                       |
|   • Take the HCE(s) with the HIGHEST DOLLAR AMOUNT and reduce them down to the next highest dollar|
|     amount contributed by any HCE.                                                                |
|   • Subtract the reduction from the Total Excess Dollar Pool.                                      |
|   • Repeat down the dollar ladder until the Total Excess Dollar Pool is 100% exhausted.           |
|                                                                                                   |
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Step 1: Ratio Leveling Mechanics (Determining Total Excess Contributions)

Under Treasury Regulation §1.401(k)-2(b)(2)(ii), the total amount of excess contributions for a plan year is calculated by determining the amount by which the elective contributions of each HCE would have to be reduced to satisfy the ADP test using the leveling method based on percentages.

The Step 1 Mathematical Algorithm

1. Determine the Maximum Allowable HCE ADP: Using the standard ADP statutory test limits based on the NHCE group's ADP:
   • If $\text{NHCE ADP} \le 2%$, $\text{Max HCE ADP} = 2 \times \text{NHCE ADP}$;
   • If $2% < \text{NHCE ADP} \le 8%$, $\text{Max HCE ADP} = \text{NHCE ADP} + 2%$;
   • If $\text{NHCE ADP} > 8%$, $\text{Max HCE ADP} = 1.25 \times \text{NHCE ADP}$.
2. Identify the HCE with the Highest Actual Deferral Ratio (ADR): $\text{ADR}_i = \frac{\text{Elective Deferrals of HCE}_i}{\text{IRC Section 414(s) Testing Compensation of HCE}_i}$
3. Hypothetically Level Down the Highest ADR: Reduce the highest ADR down to the next highest HCE's ADR. If there is a tie, reduce all tied HCEs simultaneously.
4. Recalculate the Hypothetical HCE ADP: Calculate the average of all HCE ADRs after this reduction.
5. Evaluate Compliance: If the hypothetical HCE ADP still exceeds the Maximum Allowable HCE ADP, repeat the reduction by lowering all currently tied highest ADRs down to the next highest HCE's ADR.
6. Final Fractional Leveling: Once reducing down to the next level would cause the hypothetical HCE ADP to drop below the Maximum Allowable ADP, level all tied HCEs down equally to the exact fractional percentage needed to make the hypothetical HCE ADP equal the Maximum Allowable ADP.
7. Convert Hypothetical Reductions to Dollars: For each HCE $i$ whose ADR was hypothetically reduced: $\text{Hypothetical Dollar Reduction}_i = (\text{Original ADR}_i - \text{Final Leveled ADR}_i) \times \text{Compensation}_i$
8. Calculate Total Excess Contributions: $\text{Total Excess Contributions} = \sum_{i=1}^{n} \text{Hypothetical Dollar Reduction}_i$

[!IMPORTANT] Hypothetical vs. Actual Amounts: The individual dollar amounts calculated in Step 1 are strictly mathematical abstractions used solely to determine the total dollar size of the excess contribution pool. THEY ARE NOT DISTRIBUTED TO THOSE PARTICIPANTS! Distributing the Step 1 dollar amounts directly to participants is one of the most severe and frequent operational errors tested on the ASPPA QKA exam.

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Step 2: Dollar Leveling Mechanics (Allocating Refunds to Participants)

Once the Total Excess Contributions dollar pool is determined, the plan administrator must completely discard the individual ADR percentages and perform Dollar Leveling under Treasury Regulation §1.401(k)-2(b)(2)(iii).

The Step 2 Mathematical Algorithm

1. List All HCEs by Total Elective Deferrals in Dollars: Order the HCEs from highest dollar contributor to lowest dollar contributor, regardless of their compensation or their ADR percentages.
2. Identify the Highest Dollar Amount: Determine the HCE (or HCEs) who contributed the highest absolute dollar amount of elective deferrals.
3. Reduce to the Next Highest Dollar Contributor:
   • Reduce the deferrals of the highest dollar contributor down to the dollar amount contributed by the next highest dollar contributor.
   • If two or more HCEs are tied for the highest dollar amount, reduce their deferrals simultaneously and equally.
4. Track the Remaining Excess Pool:
   • Subtract the dollars allocated from the Total Excess Contributions pool.
   • If the total dollars needed to level down to the next tier exceed the remaining excess pool, distribute the remaining pool equally among all currently tied highest dollar contributors.
5. Repeat Until the Pool Is Exhausted: Continue down the dollar ladder until 100% of the Total Excess Contributions pool has been allocated.

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|                             DOLLAR LEVELING DECISION CASCADE                                      |
+---------------------------------------------------------------------------------------------------+
|                                                                                                   |
|   HCE with Highest Dollar Deferrals (e.g., $23,000)                                               |
|         │                                                                                         |
|         ▼ Reduce to Next Highest Tier ($18,000)                                                  |
|   Amount Reduced: $5,000  -->  Deduct from Excess Pool                                            |
|         │                                                                                         |
|         ▼ Are there remaining excess dollars in the pool?                                         |
|         ├─► NO  --> STOP! Allocation Complete.                                                    |
|         └─► YES --> Multiple HCEs now tied at $18,000.                                            |
|                     Reduce ALL tied HCEs down toward next tier ($13,500).                         |
|                     Deduct total reductions from pool until pool = $0.00.                         |
|                                                                                                   |
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Comprehensive Worked Numerical Case Study

To see this two-step statutory mechanism in action, consider the following comprehensive compliance scenario for Pinnacle Engineering, Inc. for the 2025 plan year.

Testing Demographics and ADP Baseline

• Pinnacle sponsors a calendar-year 401(k) plan.
• NHCE Group ADP: 4.00%.
• Under the statutory ADP testing rules, the Maximum Allowable HCE ADP is determined using the 2% / 2x rule: $\text{Max HCE ADP} = \min(4.00\% + 2.00\%, 2 \times 4.00\%) = \min(6.00\%, 8.00\%) = \mathbf{6.00\%}$

The HCE Participant Census

$\text{Actual HCE ADP} = \frac{7.67\% + 10.00\% + 9.00\% + 9.00\%}{4} = \frac{35.67\%}{4} = \mathbf{8.92\%}$

Test Status: FAILED ($8.92% > 6.00%$. The plan must reduce its HCE ADP down to 6.00%).

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Stage 1: Step 1 Worksheet (Ratio Leveling to Find Total Excess Pool)

To reach an HCE ADP of 6.00%, the sum of the four HCE ADRs must equal $4 \times 6.00% = 24.00%$. Currently, the sum of ADRs is $35.67%$. The total reduction in ADR percentage points needed is $35.67% - 24.00% = 11.67%$.

Iteration 1: Level the Highest ADR (HCE 2)

• Highest ADR: HCE 2 at 10.00%.
• Next highest ADR: HCE 3 and HCE 4 at 9.00%.
• Reduce HCE 2 from 10.00% down to 9.00% (a reduction of 1.00%).
• New ADRs: HCE 1 = 7.67%, HCE 2 = 9.00%, HCE 3 = 9.00%, HCE 4 = 9.00%.
• New HCE ADP: $(7.67% + 9.00% + 9.00% + 9.00%) / 4 = 34.67% / 4 = 8.67%$ (Still fails > 6.00%).
• Hypothetical Dollar Excess in Iteration 1: $\text{HCE 2}: 1.00\% \times \$100,000 = \mathbf{\$1,000}$

Iteration 2: Level the Tied Highest ADRs (HCE 2, HCE 3, HCE 4)

• Highest ADRs: HCE 2, HCE 3, and HCE 4 are now all tied at 9.00%.
• Next highest ADR: HCE 1 at 7.67% (precisely $23,000 / 300,000 = 7.6667%$).
• Reduce HCE 2, HCE 3, and HCE 4 from 9.00% down to 7.67% (a reduction of $1.3333%$ each).
• New ADRs: All 4 HCEs are now tied at 7.67%.
• New HCE ADP: $7.67%$ (Still fails > 6.00%).
• Hypothetical Dollar Excess in Iteration 2:
  • HCE 2: $1.3333% \times $100,000 = $1,333.33$
  • HCE 3: $1.3333% \times $150,000 = $2,000.00$
  • HCE 4: $1.3333% \times $200,000 = $2,666.67$
  • Iteration 2 Subtotal: $$1,333.33 + $2,000.00 + $2,666.67 = \mathbf{$6,000.00}$

Iteration 3: Level All Four Tied HCEs Down to Passing ADP

• All four HCEs are tied at 7.67% ($7.6667%$). To reach the target HCE ADP of 6.00%, each HCE's ADR must be reduced by: $7.6667\% - 6.0000\% = 1.6667\%$
• Check: Leveled ADR for each HCE = 6.00%. Final HCE ADP = $(6% + 6% + 6% + 6%) / 4 = 6.00%$. PASS!
• Hypothetical Dollar Excess in Iteration 3:
  • HCE 1: $1.6667% \times $300,000 = $5,000.00$
  • HCE 2: $1.6667% \times $100,000 = $1,666.67$
  • HCE 3: $1.6667% \times $150,000 = $2,500.00$
  • HCE 4: $1.6667% \times $200,000 = $3,333.33$
  • Iteration 3 Subtotal: $$5,000.00 + $1,666.67 + $2,500.00 + $3,333.33 = \mathbf{$12,500.00}$

Step 1 Summary: The Total Excess Contributions Pool

$\mathbf{\text{Total Excess Contributions Pool}} = \$5,000 + \$4,000 + \$4,500 + \$6,000 = \mathbf{\$19,500.00}$

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Stage 2: Step 2 Worksheet (Dollar Leveling to Participants)

Now, the plan administrator must allocate the $19,500.00 pool among the HCEs. All percentages and Step 1 individual figures are now completely set aside.

Step 2, Sub-step A: Rank HCEs by Total Dollar Deferrals

1. HCE 1: $23,000.00
2. HCE 4: $18,000.00
3. HCE 3: $13,500.00
4. HCE 2: $10,000.00

Step 2, Sub-step B: Level the Highest Dollar Contributor (HCE 1)

• Highest dollar contributor: HCE 1 ($23,000.00).
• Next highest dollar contributor: HCE 4 ($18,000.00).
• Amount to level HCE 1 down to HCE 4: $\$23,000.00 - \$18,000.00 = \mathbf{\$5,000.00}$
• Allocate $5,000.00 refund to HCE 1.
• HCE 1's remaining deferral is now $18,000.00 (tied with HCE 4).
• Remaining Excess Pool: $$19,500.00 - $5,000.00 = \mathbf{$14,500.00}$.

Step 2, Sub-step C: Level the Tied Contributors (HCE 1 and HCE 4)

• Highest dollar contributors: HCE 1 and HCE 4 are now tied at $18,000.00.
• Next highest dollar contributor: HCE 3 ($13,500.00).
• Dollar reduction required per participant to reach $13,500.00: $\$18,000.00 - \$13,500.00 = \$4,500.00$
• Total dollars needed for both HCE 1 and HCE 4: $2 \times \$4,500.00 = \mathbf{\$9,000.00}$
• Can the remaining pool ($14,500.00) cover $9,000.00? Yes.
• Allocate $4,500.00 refund to HCE 1 and $4,500.00 refund to HCE 4.
• Remaining deferrals: HCE 1 = $13,500.00, HCE 4 = $13,500.00, HCE 3 = $13,500.00.
• Remaining Excess Pool: $$14,500.00 - $9,000.00 = \mathbf{$5,500.00}$.

Step 2, Sub-step D: Level the Tied Contributors (HCE 1, HCE 4, HCE 3)

• Highest dollar contributors: HCE 1, HCE 4, and HCE 3 are now all tied at $13,500.00.
• Next highest dollar contributor: HCE 2 ($10,000.00).
• Total dollars needed to reduce all three down to $10,000.00: $3 \times (\$13,500.00 - \$10,000.00) = 3 \times \$3,500.00 = \mathbf{\$10,500.00}$
• Do we have $10,500.00 in the pool? No! We have only $5,500.00 remaining.
• Divide the remaining $5,500.00 equally among the three tied contributors: $\frac{\$5,500.00}{3} = \mathbf{\$1,833.33\text{ per participant}} \quad (\text{with } \$0.01 \text{ rounding adjustment to HCE 3})$
• Final allocations from this tier:
  • HCE 1: $1,833.33
  • HCE 4: $1,833.33
  • HCE 3: $1,833.34
• Remaining Excess Pool: $$5,500.00 - $5,500.00 = \mathbf{$0.00}$. The pool is 100% exhausted!

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The Final Comparative Results: Ratio Leveling vs. Dollar Leveling

The following table demonstrates the profound difference between the Step 1 hypothetical reductions and the actual Step 2 refunds mandated by federal law:

[!IMPORTANT] The Crucial ASPPA QKA Takeaway: Notice the stunning contrast between HCE 1 and HCE 2:

• HCE 2 had the highest deferral percentage in the entire company (10.00%), which was the primary driver of the ADP test failure. Yet under statutory dollar leveling, HCE 2 receives $0.00 in refunds!
• HCE 1 had the lowest deferral percentage (7.67%), well below all other HCEs. Yet because HCE 1 deferred the largest dollar amount ($23,000), HCE 1 receives $11,333.33, representing over 58% of the entire corrective refund pool!

This outcome perfectly illustrates the Congressional intent behind the SBJPA: refunds are paid by the participants who put the most dollars into the plan, not by those who deferred the highest percentage of a modest salary.

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Applying the Two-Step Mechanism to ACP Testing (Excess Aggregate Contributions)

Under IRC §401(m)(6)(B) and Treasury Regulation §1.401(m)-2(b), the exact same two-step leveling mechanism applies to the ACP test for employer matching contributions and employee voluntary after-tax contributions:

• Amounts eliminated through ACP correction are termed Excess Aggregate Contributions (to distinguish them from ADP Excess Contributions and §402(g) Excess Deferrals).
• Step 1 (Ratio Leveling): The plan administrator hypothetically reduces the highest Actual Contribution Ratios (ACRs) down to the next highest ACR until the HCE group ACP satisfies the statutory benchmark. Summing the hypothetical dollar reductions determines the Total Excess Aggregate Contributions pool.
• Step 2 (Dollar Leveling): The total dollar pool is allocated to HCEs starting with the participant who received the HIGHEST DOLLAR AMOUNT of matching and after-tax contributions, reducing their dollar amounts down to the next highest contributor until the pool is exhausted.

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Common ASPPA QKA Exam Traps

• Exam Trap 1: Distributing Step 1 Hypothetical Reductions: Questions frequently present a scenario showing Step 1 calculations and ask, "How much should be distributed to HCE 2?" Candidates incorrectly choose the Step 1 hypothetical dollar amount ($4,000 in our example). Step 1 only calculates the total pool ($19,500); Step 2 must be performed to determine the actual distribution ($0 for HCE 2).
• Exam Trap 2: Performing Dollar Leveling by Percentages: Candidates sometimes attempt to perform Step 2 by taking the HCE with the highest ADR and giving them the highest dollar refund. Step 2 is based purely on DOLLARS DEFERRED. Deferral percentages are completely ignored during Step 2.
• Exam Trap 3: Leveling Below the Next Highest Contributor: In Step 2, an administrator cannot reduce the highest dollar contributor below the second-highest contributor before reducing both equally. If HCE A deferred $23,000 and HCE B deferred $20,000, HCE A must be reduced to $20,000 before HCE B loses a single dollar. Any excess beyond $3,000 is split 50/50 between HCE A and HCE B.
• Exam Trap 4: Overlooking Compensation Caps under IRC §401(a)(17): In Step 1, when converting ADR reductions to dollars, the compensation used cannot exceed the annual statutory limit under IRC §401(a)(17) ($345,000 in 2024; $350,000 in 2025; $360,000 in 2026). If an HCE earns $500,000, their compensation must be capped at the statutory limit before computing the Step 1 dollar reduction.
• Exam Trap 5: Confusing the Three 'Excess' Terms: ASPPA QKA exams deliberately test terminology:
  • Excess Deferrals: Violations of the IRC §402(g) individual annual limit ($23,000 in 2024; $23,500 in 2025/2026);
  • Excess Contributions: Failed IRC §401(k) ADP test amounts;
  • Excess Aggregate Contributions: Failed IRC §401(m) ACP test amounts.